The housing market is not going to bounce back because there’s a huge pipeline of severely delinquent and underwater mortgages out there that still haven’t been absorbed by the market.

Courtesy of the NY Fed, here’s concrete proof banks are sitting on huge numbers of bad loans rather than foreclosing and letting them hit the market. (Ignore the data for 2006: there were few foreclosures back then. Focus on the early 2007 to early 2009 trend.)

This first set of graphs shows the probability that once a borrower goes 60 days late, he then fails to make his next payment and goes 90 days late:

Note the percentage of supposedly “near-prime” Alt-A loans where a 60-day-late borrower cures has plunged from 25% to 5%. The percentage of delinquent loans that get repaid in full because of a refinancing (in yellow) has also dropped from low to virtually zero.

So we see once borrowers miss a couple payments they have no ability or no intention to get current.

You’d expect, with this trend, for banks to then be more aggressive about foreclosing on seriously delinquent mortgagers. Yet we see the opposite: The next set shows what banks do for loans than are 90+ days delinquent.

So banks have gone from foreclosing on about 45% of their severely delinquent Alt-A loans each month to 20%.

So if you own a house that’s underwater, in practice you can probably keep living there (or collecting rent payments) for a year or so without making payments to the bank. You have 3 months before the loan is bad enough for the bank to foreclose, around 3 more months before the bank starts the foreclosure process and who knows how much longer before the bank actually moves to take possession of your home.

On that last point, the next graph shows the declining percentage of Alt-A loans in the foreclosure process that resolve out of foreclosure (i.e., short sale or refinance) and the likewise declining percentage of these loans banks are taking possession of:

Finally we see soaring losses on first mortgages:

This would be much worse if you included second mortgages, and worse still if banks weren’t propping up the market by sitting on bad loans. Worse still, banks are sitting on bad loans in the weakest markets the longest.

Bottom line, U.S. banks are still not owning up to their bad mortgage debt. Our government is turning a blind eye hoping the problem will go away. It won’t. This policy was tried and failed in Japan, where the economy never really recovered.

In fact, the Japanese stock market lower now than it was 24 years ago in 1985:

Fox Business has just came out with an interview with Stanford Financial whistleblower Layla Wydler, who was fired from Stanford Financial Group in 2002 when she refused to participate in what seven years later has been finally exposed by federal law enforcement authorities as a “massive Ponzi scheme.”

In 2000, Stanford offered Wydler, a top broker-dealer, a sizeable salary plus a signing bonus. In exchange, Wydler made a five-year commitment to Stanford and brought her valuable book of business with her.

Red Flags

Soon after starting, Wydler became suspicious. First, the Stanford “CDs” were actually administered as a hedge fund and invested in the money market. Consequently, “Stanford was paying about 3% more than everyone else in the world was paying on CDs without explaining how he could earn that return. … [H]ow can you do that, sell a product that you call a CD when it’s really not a CD?” asks Wydler.

Second, Stanford rebuffed requests for portfolio appraisals. “[W]e would never be able to get that from them because they would tell me it’s proprietary information. [There was] a lot of mystery,” says Wydler.

Third, much like Madoff, Stanford’s audits were done by “mom and pop” accountants. “[Standord’s] financials were not audited by a U.S. reputable account[ing] firm. [Instead,] it was done by an unknown firm in Antigua. To me, that was a red flag,” states Wydler.

Fourth, Stanford would claim the CDs were insured by Lloyd’s of London. “[B]ut that’s not what it was,” says Wydler. “It was just to cover the directors and employees in case of a lawsuit, and not the client accounts at all.”

Fifth, the Stanford headquarters building had a plaque stating “Member of SIPC.” This falsely implied the SIPC’s protection covered the CDs. “[I]t’s misleading,” states Wydler. “[Y]ou [would] see the SIPC sign, [and] you would imagine that everything was safe.”

Arbitration

After Wydler refused to sell the CDs, Stanford fired her. “[T]hey wanted me to pay back the promissory note that…was a part of the signing bonus that they gave me when they hired me,” says Wydler. Stanford took Wydler to arbitration before FINRA and sought in excess of $100,000.
Wydler counterclaimed wrongful termination, alleging the firing was punishment for refusing to participate in Stanford’s Ponzi scheme. “[I]n the arbitration, we asked for the documents that would have supported the claim,” i.e., portfolio appraisals and Lloyd’s insurance policies supposedly backing the CDs, says Wydler’s attorney, Mike Falick. “And we were turned down.” Not surprisingly, the arbitrators ruled against Wydler, awarding Stanford over $107,000. (Stanford eventually settled for an undisclosed amount.)

Subsequently, Wydler reported Stanford to the SEC. However, the SEC took no action for five years. “I think there was ineptitude on the part of the regulatory agencies,” states Falick. “NSAD [the predecessor of FINRA and the agency that was responsible for this arbitration] is a self-regulatory body…charged with making [sure] the broker dealers are operating fairly and legally. The SEC is charged with protecting people. I don’t think either one of them, given the opportunities that they had and the information that they had, did what they need to do to make that happen.”

The Hefty Price Tag of Arbitral “Efficiency”

When asked whether he could have subpoenaed the documents to crack the case in court, Falick answered, “If I could’ve gotten this case out of FINRA, the day that we had the discovery issue, when FINRA told me…’we’re not gonna allow you to get those documents,’…that day it would’ve happened.”

Instead of having her day in court, Wydler was forced into a Star Chamber arbitration and panel that denied her the opportunity to support her claims with discovery and to pay the criminal organization she tried to report $107,782. So thanks in part to NASD’s arbitrators, the fraud was allowed to continue for five more years until it finally collapsed under its own weight.

“I asked for the documents that would’ve proven her case and we were stonewalled by Stanford and we were told by FINRA that our document request was irrelevant,” says Falick. “[H]ad we gotten those documents, not only would Leyla have won her case, but maybe 30,000 people wouldn’t have lost their life savings.”

“[W]hen I left, I believe that there was about a billion dollar in the bank,” says Wydler. “[I]t ended at 7.2 billion.”

As an attorney, my advice to my clients is to refuse to participate in any binding arbitration unless they were aware of and understood what arbitration entails at the time they signed the contract containing an arbitration clause. Increasingly courts are recognizing that essentially businesses are using private arbitrators to shield them from the consequences of their lawbreaking, and refusing to enforce arbitration clauses.

Calculated Risk for years has provided better economic forecasts and data collection than the expensive paid services with their relentless bubble boosterism.

I also owe him personally for helping to expose the ticking time bomb of subprime and option-ARM mortgages way back in 2006. That was a very good year for my personal portfolio! Nonetheless I have to disagree with his mild optimism on housing expressed here:

He argues that residential investment may have reached bottom earlier this year, and their recovery in Q3 and Q4 will boost the rest of the economy, and also points to possible recoveries in autos and business inventories.

I think, more likely, these “green shoots” will soon be overwhelmed by the continuing collapse of much of the rest of the economy.

Even if autos and residential RE construction recover somewhat, what about the following:

Banks without cheap federal financing?

State and local government spending?

Commercial real estate?

Unemployment and income declines?

Decreasing velocity of money due to high marginal propensity to save?

Rolling waves of defaults as cheap bubble debt matures, from Option ARMs to leveraged loans to credit cards to commercial lines of credit?

The hundreds of thousands of small and medium-size businesses affected by the impending CIT Group bankruptcy and the massive closing of unsecured credit lines by Amex and Adventa earlier this year?

Each of these are contributing to deflationary headwinds that, in my opinion, will smother any spark of recovery in real estate or autos for at least the next three quarters.

If you have uninsured deposits in any of these three banks–Downey Savings (CA, AZ), FirstFed Financial (CA), or Bank United (FL)–by all means take them out as soon as possible. There is a substantial chance that you will face losses on the scale of IndyMac’s uninsured depositors.

Lest I seem to be a complete bear, at the same time I think now may be a good time to invest in conservative utility stocks like DPL, clean energy funds like PBW, and clean energy stocks like TSL. I am still very impressed with the growth story of Starbucks (SBUX), Google (GOOG), and China Mobil (CHL), which are down substantially from their highs. More adventurous investors might consider investing in some GM bonds now yielding 17% (XGM).